This week Ben Bernanke and his colleagues at the Federal Reserve are holding their usual FOMC meeting to decide on the next course of action for the nation's monetary policy. “Taper” is the word of the month. Tapering refers to the Fed’s alleged intentions to slow down its asset purchasing program, also known as Quantitative Easing, and this policy keeps market participants awake at night. It took an offhand comment from Fed Chairman Ben Bernanke last month for markets to begin to zigzag. Many market players interpreted Bernanke’s suggestion that the Fed could change course “in the next few FOMC meetings” depending on prevailing economic data as a run-for-the-hills type of scenario. Bond yields rose to their highest level in a year and the stock market has suddenly awakened from its upward bound tranquility. For some reason everyone decided to give more weight to the “could change course” part of Bernanke’s statement than the “depending on prevailing economic data” part. But in more sober quarters no big change in policy is expected at Tuesday’s FOMC meeting.
To speculate on Bernanke’s next move and the timing of the move, one must be familiar with the tools that are currently available to the Fed chairman. Bernanke has simultaneously used two mechanisms to fight the recession:
1. Quantitative Easing (QE), currently at $85bn monthly — massive purchases of agency and mortgage-backed debt from the banks.
2. A mandate to raise (or cut) fed funds rates (the Fed does the former to cool down the economy, and the latter to spur growth).
Bernanke will not turn off both programs at once.
Before Bernanke even touches the fed funds rate, first he will very gradually reduce the asset purchases, perhaps cutting it by a small fixed amount every month. And yet, before he does even that, Bernanke would like to see real, consumer-driven inflation to materialize as it would indicate a growing economy — the very goal he’s been trying to achieve. So when we eventually see inflation pick up (not via rising bond yields, but via economic indicators such as consumer prices), it will be a cause for celebration, not concern. That’s what Bernanke means when he says “depending on prevailing economic data”. He wants to see real growth, reflected in improving economic indicators, not in bond yields, which are for now receiving all the attention among the CNBC chattering crowd.
So tapering will be a long, cautious, and gradual process that is open to revision depending on the economic indicators.
Growing bond yields, in the realm of alarmists and bond vigilantes, indicate the increased demand for risk premium from the usual U.S. creditors. But could this selloff in bonds simply be a sign of massive bond portfolios anticipating the Fed’s “tapering” and reducing their exposure, rather than investors falling out of love with U.S. Treasury bonds? Could it be a simple overreaction of portfolio managers holding massive amounts of U.S. debt accumulated in the bond rally over the last few years rather than a reaction to an imaginary deterioration in U.S. economic data? (The United States' economic situation is actually improving). Moreover, whether big investors are shunning U.S. Treasury bonds due to worsening U.S. economic conditions or because they're anticipating the Fed’s aggressive tightening, then where exactly are they going to go? Judging by the selloff in EM bonds, the shift is actually happening in the opposite direction — into the U.S. Treasuries, especially now that they earn 2.2% as opposed to 1.6% a month ago. U.S. Treasuries, in other words, is still the least dirty shirt in the world’s closet.
And stocks, as history tells us, usually respond to the Fed’s raising interest rates by rallying. And why not? After all the Fed’s tapering is an indication that the economy could stand on its own two feet, not an indication of an upcoming apocalypse.
So my bet is that we won’t see any drastic talk or actions this week.